Financial derivatives, also known as contingent claims, are special types of contracts used by financial risk managers to hedge against the fluctuations of more basic underlyings throughout time. Throughout this document, the term underlying is defined as in FAS Statement 133, appendix A, paragraph 57, a. In the recent years, derivatives have become increasingly important in the field of finance. According to the latest report from the Bank for Internationals Settlements (BIS) on Derivatives activity, the notional amount on all derivatives positions held by trading institutions stood at over 187 trillion dollars at the end of year 2000 (this value represents the sum of contracts traded through exchanges and over the counter). The financial industry has responded to this growth in the derivatives market by developing new methods and systems to price and hedge derivatives contracts and to facilitate trading in derivatives contracts.
The following problems are known to limit the accuracy in present approaches to price and hedge derivatives contracts, hence the ability to most efficiently and effectively trade derivatives contracts:    a) a) The current approaches to valuing derivatives make the assumption that hedging is done in continuous time, while in practice, participants hedge their positions in discrete time increments. Therefore, the existing approaches used in the financial industry or suggested by the academic community do not accurately account for this inherent discrepancy and are limited in accuracy when applied to real markets and the pricing of derivatives.    b) Current approaches to valuing derivatives assume that markets are frictionless—bid/offer spreads are reduced to zero, order size does not affect price or inventory, slippage effects and credit risk are non-existent. In reality, however, markets are not frictionless. While theoretical methods have been suggested to address this problem, they still inadequately reflect real market situations. This forces practitioners to use sub-optimally efficient methods.    c) The current methods for derivatives pricing and hedging depend on the dynamic of underlyings model, thus creating a model risk that can be very costly if not accounted for in practice.    d) The current methods for derivatives hedging use parameters known as Greeks. Greeks are obtained by differentiating price with respect to various other model parameters. The implicit assumption behind using Greeks is that derivatives prices are polynomial functions of these other model parameters. This is not true and therefore the use of Greeks in hedging creates an additional source of approximation error that can be costly in practice.    e) The current methods for derivatives pricing and hedging assume that the underlyings move in infinitely small increments while in practice for all markets there is a minimum increment size often referred to as a tick or a pip.    f) When not assuming continuous time, the current methods for derivatives pricing deal only with a single future period or single underlying scenario. In reality, there are multiple periods and underlyings to consider.    g) The existing methods that do attempt to address all these shortcomings are intractable in practice and thus fail to provide the benefits they were set up to yield.
A vivid example of the potential cost and risk to the financial system of the inaccuracies discussed above is the collapse of the hedge fund Long Term Capital Management (LTCM), where the Nobel Prize winning fund managers relied on a model from which the market deviated. The real market deviation from the model led to an exposure of about one trillion dollars, prompting the federal reserve to engineer a bailout to avert a failure that would have otherwise disrupted the whole U.S. financial system and could have easily have extended to all international markets (See for example “When Genius Failed: The Rise and Fall of Long-Term Capital Management” by Roger Lowenstein ISBN 0-375-75825-9 [46])
There is a substantial body of academic and published patents addressing derivatives trading issues. The relevant patents and patent applications found can be classified into five categories, as described below.    1. Patents that provide methods and systems to price specific types of derivatives. In this category, we can note U.S. Pat. No. 4,642,768, U.S. Pat. No. 5,799,287, JP 2001067409    2. Patents that provide methods and systems to automate the derivatives pricing process. In this category, we can note U.S. Pat. No. 6,173,276, U.S. Pat. No. 5,692,233, and patent applications US20020010667 and US20020103738    3. Patents that provide methods and systems to speed up the derivatives pricing process. In this category, we can note U.S. Pat. No. 5,940,810 and U.S. Pat. No. 6,058,377.    4. Patents that provide methods and systems to better hedge derivatives or manage the risk of derivatives books. In this category, we can note, U.S. Pat. No. 5,819,237, U.S. Pat. No. 6,122,623 and patent applications US20020065755 and WO0133486    5. Patents that provide methods and systems to more efficiently trade specific types of derivative contracts. In this category, we can note U.S. Pat. No. 4,903,201, U.S. Pat. No. 5,970,479, U.S. Pat. No. 6,421,653, U.S. Pat. No. 6,317,727 and U.S. Pat. No. 6,347,307
All those patents while presenting benefits over their prior art face limitations addressed in this invention.
In a recent article in the Journal of Finance on patenting in the field of finance methods and formulas, the author1 found problematic the failure to cite academic research in prior art reviews of patent applications or granted patent. Our detailed description thus start by reviewing reviewing the academic literature. 1Josh Lerner “Where does State Street Lead? A First Look at Finance Patents, 1971-2000” THE JOURNAL OF FINANCE VOL LVII, NO 2 APRIL 2002 [45]